What sank Asia? Money sloshing around the world

By Robert Kuttner, Business Week, 27
July 1998

We are learning once again the fundamental difference between free
commerce in ordinary goods and free commerce in money. The former is
broadly efficient—it subjects business to bracing competition
and allows products to find markets anywhere in the world. The latter
is destabilizing and deflationary—it holds the real economy
hostage to the whims of financial speculation, which is vulnerable to
herd instincts, manias, and panics. In ordinary commerce, prices
adjust and markets equilibrate. In global money markets, erratic and
damaging overshooting is the norm.

Exhibit A is, of course, the Asian crisis. The Asian collapse is
widely blamed on structural problems—too much state interference
in economies, crony capitalism, and thinly capitalized
banks. But that system, while in need of overhaul, did produce
exceptional growth for two decades. The more important cause of the
Asian crisis is the sudden exposure of these nations to the
speculative whims of unregulated financial capital. It is impossible
to run an efficient economy when your currency swings by 100% in just
a few months.

EASY TARGETS

The fundamentals of most Asian economies remain enviable—high
savings rates, well-educated and disciplined workforces, high rates of
productivity growth. However, when these economies became targets for
global financial speculation, they were abruptly exposed to forces
beyond their control. Hot money poured in, seeking supernormal
returns. When the hot money resulted in overbuilding followed by
falling expectations, the money poured out just as quickly. To
reassure the same global speculative capital, these nations,
encouraged by the International Monetary Fund, resorted to tight money
and deep economic contraction. The kowtowing to skittish financial
markets has led to generalized deflation.

In popular memory, John Maynard Keynes is (wrongly) associated with
simple deficit spending. But at the heart of the Keynesian insight
about the failure of markets to self-regulate is the disjuncture
between the real economy of long time horizons with fixed obligations
and the short-term, often irrational character of financial markets.

The Bretton Woods system was an attempt to square this circle. Bretton
Woods married free commerce in goods to regulated commerce in
money. It created fixed exchange rates and controls on private capital
movements—precisely so that free trade in goods could coexist
with high growth and full employment. Financial speculators had no
role in the Bretton Woods system, so there was no systemic bias in
favor of slow growth.

Bretton Woods collapsed, however, because it was never anchored by the
global credit system envisioned by Keynes. Rather it was temporarily
anchored by the U.S. dollar. But when the need to finance expanding
global commerce collided with the need to maintain domestic price
stability, dollar hegemony became too great a stretch. The
U.S. sacrificed fixed exchange rates, finally ending the Bretton Woods
system in 1973. It is more than a coincidence that 1973 also began the
era of slower growth.

SAFETY NET

With the collapse of Bretton Woods, a new generation of free-market
fundamentalists insisted that money was just another commodity with
prices set by markets like the price of ordinary goods. Exchange rates
should float; all capital markets should be totally permeable. Recent
events, however, have proven this view tragically wrong.

If we are not careful, the world will enter a deflationary spiral not
unlike the Great Depression, triggered by events in Asia. The American
architects of Asian rescue can’t decide whether they trust
speculative markets to govern flows of currency and capital. On the
one hand, the Clinton Treasury backs the IMF view—liberalize
capital markets, get government out of the way, reassure investors. On
the other hand, Treasury Secretary Robert Rubin talks of the need for
Asian social safety nets; he encourages Tokyo to bail out its banks
and urges the Chinese to keep pegged exchange rates—none of
which policies exactly reflect deference to market forces. The policy
muddle reflects an intellectual muddle.

Ad hoc damage control coupled with self-defeating austerity is the
wrong approach. Better to act systemically, with a Tobin Tax on
short-term currency transactions, as well as a more managed system of
capital flows and exchange rates. It remains to be seen whether
today’s statesmen can rise to the occasion or whether they are
still prisoners, as Keynes once put it, of the ideas of defunct
economists.